Automatic Tipping and the IRS: Impact on Restaurants

Automatic tipping tends to be a hot-button item but is making the news now because of a change in the tax code. The IRS will change the classification of automatic tips to service charges and treat them as regular wages which would be subject to payroll withholding tax starting in the new year. Previously, these gratuities were left to the employee to report as income as with non-automatically calculated tips. The change is making waves with both restaurants and wait staff.

The practice of automatically calculating tips has typically applied to large parties to help ensure that servers weren’t shortchanged on large tabs.

For restaurants, the tax change means added paperwork and more complicated payroll accounting. Automatic tips would need to be factored into pay and would cause a fluctuation in the actual hourly rate, depending on how many large parties a particular employee served. Further complicating matters, restaurants must report to the IRS the amounts employees report receiving as tips in order to pay Medicare and Social Security taxes on those amounts. And to take even a step further, restaurants may be eligible for income tax credits on some of those payments, excluding service charges.

Additionally, many employees are unhappy with the change. Most collect their tips at the end of their shifts. Changing automatic tipping to a service charge and rolling it into payroll would mean that those monies wouldn’t be seen by the employee until a regular payday.

To Tip or Not To Tip

The IRS updated its ruling since it viewed automatic tipping as mandatory rather than voluntary, making it a service charge rather than a gratuity. A case in which a restaurant recommends a gratuity would not be subject to federal withholdings.

Of course, tipping is deeply ingrained as an incentive for good service. However, research from Cornell University (as cited in The Week) notes that customers rarely vary the amount they tip. If they typically leave 20 percent, they’ll leave 20 percent regardless of the actual service and courtesy they received.

Some have called for an end to tipping entirely and paying wait staff a fair wage instead, claiming that it would be good across the board – from the customer right through to the back of house. Restaurants’ concern is an objection to higher prices (covering higher wages through meal costs) and a concern that customers don’t want to relinquish how much to tip.

Many large chain restaurants, including Darden Restaurant, Inc. (owner of Olive Garden, Red Lobster, and LongHorn Steakhouse) and Texas Roadhouse, Inc. are reviewing their policies regarding automatic tipping and planning to phase out the practice (or are considering it) by the end of the year to avoid the associated costs and headaches.